AALS 09 Hot Topic Panel On Fin.Crises
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Transcript of AALS 09 Hot Topic Panel On Fin.Crises
Why Has This Epidemic of Accounting “Control Fraud”
Caused Catastrophic Losses?
William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City
AALS “Hot Topics” Panel on the Financial Crises
January 9, 2009
Criminogenic Environment:
Accounting Fraud Epidemic
Non-regulation & desupervision
Plus three critical “vectors”
• Securitizing & rating agencies
• Credit default swaps
• Perverse compensation incentives: Gresham’s dynamic
BackgroundStaff leader of the successful
reregulation of S&L industry
Defeats “control fraud” epidemic
“Coroner” – autopsied failures
Designed the economic studies
Fraud: “invariably present”
Recognized pattern: triage
Achilles’ heel: limited growth
Burst SW real estate bubble
“Control Fraud”1. CEO uses firm as a “weapon”
2. Apparent legitimacy & power
3. Accounting: “weapon of choice”
4. Causes more losses than all other property crimes combined
5. Control frauds can kill & maim
Synthesis of criminology, finance, law, economics & accounting with implications for each field.
Optimizing Accounting Fraud
1. Assets w/o clear mkt. values
2. Yield, not risk, is the key
3. Loan to the worst borrowers
4. Bad underwriting is good
5. Cover up defaults & book new income by refinancing
6. Grow rapidly – Ponzi
7. Make your “controls” allies
Focus on Rating Agencies
Mortgage bankers were always the mortgage cowboys
Constrained by inability to grow
Freed by nonprime securitization
Which was freed by AAA ratings for “toxic waste”: SIVs & CDOs
Created “originate to sell” model
Mortgage Fraud “Epidemic”
FBI warned of it in 9.04
80% of it induced by lenders
Fitch: nonprime incidence >40%
FY07: >50,000 criminal referrals
Investment bankers (03-07): made 34 referrals
Unregulated: 80% nonprime loans
50K is a massive underestimate
Epidemic, What Epidemic?
“Sophisticated models, combined with strong risk management, allow lenders to better quantify the credit risk associated with scaling back the verification of a borrower's income and assets.” [Moody’s 11.24.04]
Moody’s explanation for weakening its standards on “low doc” loans.
Economic Implications
Massive direct losses fatal to any lender/buyer – hidden
Perverse econometric models
Hyper inflate & extend bubble
Maximize “adverse selection” and info. asymmetry – Lemon’s
Deceit: create & betray trust – cause markets to shut down
Securitization Implications
Unsafe at any price
Why only 34 referrals?
No one did any due diligence
Don’t ask; don’t tell
“Most sophisticated” risk raters ignored the worst credit risk
Potemkin models of mendacity
Paradox of “predatory lending”
Rating Implications
Ignored worst underlying risk
Ignored fraud epidemic warnings
Ignored housing bubble
Pineapple v. grenade comparison
Ratings were farblondget
Toxic waste transformed into AAA
Dishonest: CDO credit v mkt. risk
Made rating business “lucrative”
It’s Not Insane; It’s Fraud
Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so. [S&P ’01]
See no evil….
“There's a lot of fraud that's involved there, things that we didn't see.
We're on notice that a lot of things that we relied on before just weren't true. [W]e relied on reps and warrantees that no loans were originated in violation of any … law. We know that's a lie.” Moody’s ’07
Gresham’s dynamic
“[I]t was a slippery slope. What happened in '04 and '05 with respect to subordinated tranches is … our competition, Fitch and S&P, went nuts. Everything was investment grade. We lost 50% of our coverage [business share]….”
[Moody’s 2007]
“Most Investors Don’t Have It”
Purchased >$1T nonprime loans
During a fraud epidemic
Buy liar’s loans w/o fraud checks
CDO & CDS: can’t know risks
Spreads narrowed – increasingly inefficient, inflated markets
Can’t know values, can’t trade
Vectors for Fraud Epidemics
Didn’t shift risk to best able to bear
Concentrated, spread & increased losses
Made markets far less “efficient”, the spread narrowed as losses grew
Killed our most elite banks: no relevant expertise or data
Spread the crisis globally & shut down many markets
Unintended Consequences
1. Non-regulation, deregulation & desupervision = no cops on the beat. Decriminalizes, de facto, control fraud.
2. Opaque markets; lack of independent verification of asset values: markets fail.
3. Optimal criminogenic environments – securitization